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Irreversibility and Optimal Timing of Climate Policy

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Abstract

We focus on the optimal timing of climate change mitigation policies, a decision which is complicated by multiple sources of irreversibility or inertia. The pertinence of Real Option Theory in understanding the optimal amount of necessary precautionary behavior is explored, as are the results from modeling exercises. Generally, it appears that irreversibility associated with sunk abatement capital is stronger than that from accumulating greenhouse gas emissions, implying an "option value" to delaying climate change mitigation. The inclusion of tipping points, or non-linearities in environmental damages, could nevertheless lead to the opposite conclusion. These effects are however not easily quantifiable and are not generally included in modeling exercises. The timing decision will therefore have to be made by policy makers after having subjectively evaluated the importance of potential tipping points. It is for this reason that policy-makers need to be able to themselves understand the intuition behind Real Option theory - the interplay between irreversibility and uncertainty. Many climate-economic modeling exercises have implicitly recognized this fact by integrating strict environmental targets which serve as hard constraints and represent precautionary behavior.

Suggested Citation

  • Justin Caron & Markus Ohndorf, 2010. "Irreversibility and Optimal Timing of Climate Policy," IED Working paper 10-14, IED Institute for Environmental Decisions, ETH Zurich.
  • Handle: RePEc:ied:wpsied:10-14
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    File URL: http://www.ied.ethz.ch/pub/pdf/IED_WP14_Caron_Ohndorf.pdf
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    Cited by:

    1. Salvatore Di Falco & Marcella Veronesi, 2014. "Managing Environmental Risk in Presence of Climate Change: The Role of Adaptation in the Nile Basin of Ethiopia," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 57(4), pages 553-577, April.
    2. Julia Blasch & Mehdi Farsi, 2012. "Retail demand for voluntary carbon offsets - A choice experiment among Swiss consumers," IED Working paper 12-18, IED Institute for Environmental Decisions, ETH Zurich.
    3. Ines Kapphan & Pierluigi Calanca & Annelie Holzkaemper, 2011. "Climate Change, Weather Insurance Design and Hedging Effectiveness," IED Working paper 11-17, IED Institute for Environmental Decisions, ETH Zurich.
    4. Thomas Epper & Helga Fehr-Duda & Renate Schubert, 2011. "Energy-Using Durables: The Role of Time Discounting in Investment Decisions," IED Working paper 11-16, IED Institute for Environmental Decisions, ETH Zurich.
    5. Verbruggen, Aviel, 2013. "Revocability and reversibility in societal decision-making," Ecological Economics, Elsevier, vol. 85(C), pages 20-27.
    6. Salvatore Di Falco & Marcella Veronesi, 2011. "On Adaptation to Climate Change and Risk Exposure in the Nile Basin of Ethiopia," IED Working paper 11-15, IED Institute for Environmental Decisions, ETH Zurich.
    7. Michele Baggio, 2012. "The Optimal Management of a Natural Resource with Switching Dynamics," IED Working paper 12-19, IED Institute for Environmental Decisions, ETH Zurich.
    8. Salvatore Di Falco & Marcella Veronesi, 2011. "On Adaptation to Climate Change and Risk Exposure in the Nile Basin of Ethiopia," IED Working paper 11-15, IED Institute for Environmental Decisions, ETH Zurich.

    More about this item

    Keywords

    irreversibility; inertia; uncertainty; optimal timing; climate policy; real options;

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming
    • Q58 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environmental Economics: Government Policy

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